May 9, 2023 | By Sahand Elmtalab & Eric Annett

BACKGROUND

SO, WHAT'S THE PROBLEM?

THE SHOW WILL GO ON

   Even if the Dollar were to somehow disappear entirely from international trade it is profoundly unlikely any such transition could happen rapidly(3,4). The United States, the Dollar, and Dollar-based systems are simply too important and too deeply embedded into the world’s financial infrastructure to allow for there to be any reasonable expectation of that happening. The following chart shows the total world share of foreign exchange reserves held around the globe, and the Dollar is by far the most owned. This is largely by necessity: over 66 countries peg the value of their currency to the Dollar, so they need to keep large Dollar-denominated holdings to maintain their foreign exchange rates. There are also countries who are heavily involved in commodities trading since most commodities are priced in Dollars.

Source: Visual Capitalist, “De-Dollarization: Countries Seeking Alternatives to the US Dollar”.

Article by Bruno Venditti, graphic by Sabrina Lam. Published March 31, 2023

   One thing immediately stands out from this chart: despite the US accounting for about 25% of global GDP in nominal terms, the Dollar accounts for 60% of forex reserves. Why is this? Outside of the obvious political and military influence the United States wield over the world, we believe the Dollar’s continued status as the global reserve currency can be justified by four essential reasons:

1.     Stability

2.     Liquidity

3.     Barriers to Exit, Lack of Alternatives

4.     Open, Transparent Markets

Stability

   Consider the four main functions of money: a medium of exchange, a standard of deferred payment, a store of wealth, and a measure of value. Clearly, stability is a necessary condition that underwrites all these functions, or else fiat money would likely not be possible. A system of money that cannot be trusted as a stable store of value or unit of exchange is not a system of money that is going to be widely adopted. Therefore, it is easy to see a connection between the Dollar’s hegemony and the remarkable run of stability enjoyed by the United States since WW2. When Western Europe and Japan were decimated by the war; Eastern Europe, China and other parts of Asia were succumbing to communism; and when Latin America underwent numerous revolutions and counterrevolutions, the United States stood alone as a major world power with an intact economy and an enduring system of government. While Germany, England, France, and Japan were all rebuilt and remain major powers, none ever became large enough to challenge the might of the US economy.

   But it wasn’t a case of merely being outgrown. The United States have a better track record than most the rest of the developed world as a borrower as well. The United States to this day remain one of few countries who have never defaulted on their external debt, and the only nation of a comparable size in population or GDP who can say the same is Canada(2). Although recent decades have seen the US abandon its practice of maintaining prudent and sustainable debt levels, there are not many nations left who can say they haven’t.

LIQUIDITY

   Even more so than stability and the reserve currency status, the largest engine of international demand for Dollar assets might be the US’ unparalleled liquidity. The US has the deepest financial markets in the world, which makes them nearly unrivaled in ease of doing business(15). Liquidity is a key characteristic needed for accurate, efficient pricing, which minimizes transaction costs and allows for markets to react to new developments quickly and accurately. Having accurate prices free from distortion by inaccurate info or unnecessarily wide spreads facilitates higher transaction volume, which contributes even further in terms of price discovery. Countries would be averse to holding substantial reserves of money they could not quickly and efficiently transact in; after all, what good is a medium of exchange that can’t be easily exchanged?

   To illustrate how deep the US markets are compared to the rest of the world, we look to the Bank of International Settlements’ triennial survey on forex turnover, most recently published in 2022(12,13). By transactional volume, no currency came close to the US Dollar, which saw over $1.8 trillion of daily volume in spot transactions. The second-most traded currency is the Euro, whose spot volume came in at $616 billion. Even after making an impressive jump from a 4% market share to 7% since the 2019 triennial survey, the Chinese Yuan, the fifth-most traded currency, could increase tenfold from its level and still have a lower daily spot volume than the Dollar.

BARRIERS TO EXIT & LACK OF ALTERNATIVES

   Consider the Euro. The second most-used currency on Earth, it would still need to take at least ten percent of the Dollar’s current market share to equal the current transaction volume of Dollars in SWIFT, the primary global financial payments system. That would amount to hundreds of billions of dollars per day going from the Dollar into the Euro(4).  

   Given the structural challenges facing the globe’s other major economies, it is unclear where such demand would come from, even if aided by major commodity exporters becoming increasingly open to trade in local currencies. Other nations would still need to hold Dollar reserves for trade with the United States or any other nations who would prefer to continue transacting in Dollars. And this is to say nothing of the long list of countries who opt to peg their currency to the Dollar via a fixed exchange rate instead of letting it freely float on the market. Saudi Arabia, the UAE, Qatar, China (Yuan), Singapore, and Hong Kong are among the most notable to peg their currencies to the Dollar(14), which means even if they were to reduce or cease their use of Dollars in trade, they would still need to hold significant Dollar reserves to maintain these pegs. Of course, they could explore abandoning their currency pegs as well, but that is unlikely to be a palatable option or else they probably wouldn’t peg to the Dollar in the first place.

OPEN & TRANSPARENT MARKETS

   The liberalized markets of the US are yet another draw for international capital. Capital controls are measures taken by governments and/or central banks to regulate the cross-border flows of capital in the country. Most commonly, they are used to either prevent foreigners from purchasing domestic assets or to prevent flight of domestic capital into foreign nations. Their aim is to reduce exchange rate volatility and provide stability, though in practice they are typically associated with autocratic regimes who maintain bad economic policies. Such controls tend to be stricter in developing economies due to vulnerability and volatility of their capital reserves compared to developed countries. While nations like Argentina, Brazil, China, India, Greece, and Russia have histories of using aggressive capital controls to limit foreign influence and investment in their markets, the United States are fully open, with no restrictions on what US assets you can buy provided you have enough Dollars to buy them(10). The US also maintains no formal exchange rate policy, meaning the value of the Dollar fully and freely floats, determined by the markets and not by any central bankers or bureaucrats.

THOSE IN GLASS HOUSES...

   As for who would be at the forefront of a de-dollarized global economy, most attention has been thrown at the rise of the BRICS (Brazil, Russia, India, China, and South Africa); a trading bloc formed in the wake of the global financial crisis which was initially spearheaded by Russia. The aim of the first BRIC Summit in 2009 (South Africa would join to make it the BRICS in 2010) was to explore how to “overcome the crisis and establish a fairer international system (…) and discuss the parameters for a new financial system.” Since its formation, the BRICS have made many advancements in economic cooperation, including creation of the New Development Bank (NDB), the Contingent Reserve Arrangement (CRA), and other multilateral efforts intended to serve as an alternative framework to existing institutions such as the World Bank and International Monetary Fund. The aims of these programs are similar, though a key difference is that the BRICS’ versions of these institutions deal in local currencies rather than solely the Dollar and are headed by BRICS members rather than an American or European.

   Some may view this as a coming paradigm shift, pointing to the decline of the Dollar’s share in Russia-China trade settlement from 90% in 2015 to 46% in 2020. Believers can also point to the collective economic power of the group. BRICS accounts for 24% of world GDP and over 16% of world trade(6). But the devil is in the details, and despite their combined economic might, the BRICS nations are far from offering a coherent, unified alternative to the United States’ global leadership(6).

   China, the largest BRICS member, is the most prominent example of a country using capital controls as an authoritarian bludgeon rather than to merely provide a safeguard against volatility. They do not have open capital markets, meaning foreigners cannot buy Chinese hard assets, and the currency available to foreigners (the Yuan) is separate from the currency in use domestically (renminbi)(3,10). The Chinese Communist Party under Xi Jinping has been trending in the direction of consolidating and exerting greater state control over the economy, not less, making it very unlikely they would be comfortable liberalizing their capital markets and subjugating their tight grip on power to international market forces(10). However, keeping their capital account closed to the outside world also creates a lack of transactional opportunity for the Yuan’s share of the forex market to approach the Dollar’s.

   Since 1942, Brazil has had eight different currencies, starting with the Cruzeiro, and working its way towards the present-day currency, the Real, introduced in July 1994. Brazil’s history of extreme boom-and-bust cycles, persistent high inflation, and abrupt currency crises mean the Real is not likely to be winning any fights against the Dollar any time soon(19).

   Russia, after a decade that involved forceful annexation of territory, interfering in foreign elections, and the invasion of Ukraine, is a global pariah. While they haven’t been entirely cut off from international markets due to those like China and India still being more than willing to keep importing Russian oil despite Western sanctions, their economy has become severely crippled by the loss of trade with the United States, the EU, and the others who have participated in sanctions. It seems it will be a very long time before Russia regains any trade political or trade relationships with the West. In response to US sanctions, Russia has tried to introduce alternative trade settlement systems to SWIFT, such as SPFS, which couldn’t even gain traction within the BRICS(6). Russia was not a very large player in international trade outside of the energy markets to begin with, so it is unlikely Russia, or the Ruble, will be at the global forefront of Dollar alternatives, even if they constitute a loud voice in support of de-Dollarizing efforts.

   India is a BRICS member who could ultimately pose a threat to the Dollar system(7). India has the most rapidly growing economy on the planet, and unlike the United States, Japan, and China, who all have rapidly aging populations and falling birth rates, demographics are also on India’s side. The median age of a person in India is 28.7 years old, compared to 38.4 in China, 38.5 in the US, 40.3 in Russia, 47.8 in Germany, and 48.6 in Japan(16). Its birth rate of 2.1 births per woman is also much faster than in the US (1.6), Japan (1.3), or China (1.3)(17). So given these figures, India, already the world’s most populous country, should be on track to overtake China as the world’s largest economy eventually. India has remained frustratingly independent over the years; they do maintain a friendly and cooperative relationship with the United States, but also continue do the same with Russia(7). Indeed, New Delhi did not join in with the West on condemning Russia’s invasion of Ukraine and nor did they participate in sanctions on Russia. They instead have used the war as an opportunity to build up partnerships with Russia, deepening their trade relationships and accelerating the build-out of their own financial infrastructure. However, there have been signs of a souring relationship with China. After a series of border disputes in 2020, India banned dozens of Chinese apps, including TikTok, and they maintain much tighter and scrutinized capital controls on Chinese investment into India than they do compared to other foreign money(18).

   So, while India perhaps offers some future potential as a nation whose economy and currency will grow into larger global roles in the future, all things considered a major BRICS-led Dollar alternative seems unlikely. In addition to the reasons listed above, there is one major reason yet to be touched on for why the BRICS coalition is a doomed challenger to US dominance, and it’s competing visions within the bloc. BRICS does not represent one coherent set of ideals or system of commerce. The obvious elephant in the room is the massive power asymmetry between China and the rest of the bloc. There are also varying systems of government, from China’s strict authoritarian communism to Putin’s brand of strongman dictatorship, to India representing the planet’s largest functioning democracy. Through the economic lens, there’s also China’s unique brand of communism with market influence, Russia’s crony capitalist system rife with oligarchs and plutocrats, South Africa utilizing a more classic mixed economy, and on the other end Brazil and India having relatively liberalized economies. Corruption has been a common element across all these nations, as is the fact that all five have at one point or another experienced US sanctions. Things may be easy and harmonious right now while the five agree on the goal of seeking alternative trade methods outside the Dollar, but we’ll see how their cooperative spirit holds up when their many differences are put to the test. The BRICS are headed toward a dilemma if they do succeed in the de-Dollarization push, because devaluing the Dollar also means devaluing Dollar-based assets(6). Is China, the largest holder of such assets, going to want to push this as far as say, a country like Brazil? While China is on the other end of by far the US’ largest trade deficit and pegs the Yuan to Dollars (and thus, is a massive holder of Dollars), the US has a trade surplus with Brazil and the Real floats freely without a currency peg, so Brazil would have far less to lose. What then?

THE IMPLICATIONS

   So, what does this all mean for the Dollar, and are there any investment implications to look for? The short answer is that we believe the Dollar’s dominant market position is likely here to stay for the foreseeable future. At the same time, there are countries with significant enough economic power who have reached the point they’re looking for other alternatives, the two primary reasons we are of the opinion this is not something to fret over are firstly, that the primary motivation for this is really rooted more in looking to evade US oversight and potential sanctions than it is taking place for any purely economic reason; and second, as we have covered fairly extensively, there is no ready-made alternative waiting in the wings that can step in and provide the same advantages as a global reserve currency that the Dollar has and continues to offer.

   The worst-case scenario in the short to mid term is perhaps the increased interest in de-Dollarizing efforts results in a more multipolar system where the Dollar remains the dominant currency, but other regional powers see their currency take up a greater role in certain trade relationships, especially some of those centered on commodities. Arguably, there may be some benefit to this, as the Dollar’s market share has become so dominant that it might be a good thing to diversify the global currency regime somewhat. In the longer term, what could happen is anyone’s guess, as there seems to be enough of an appetite for moving away from the Dollar that it would be foolish to say it could never happen. There may be a lack of viable alternatives right now, but that will not always remain the case. Eventually, a workable idea is bound to emerge. But we do think that day is still quite a long way off from here.

   If the Dollar were to see its market position decline, it may result in three primary outcomes. The first and most obvious is a decrease in demand for Treasury bonds. If countries are holding less Dollars, then they won’t need as many Dollar-denominated bonds, which should translate into lower values and higher yields on outstanding US government-issued bonds. Furthermore, declining Dollar strength has also generally been a positive for international valuations, both equities and fixed income. This would imply higher returns in international stock markets, and lower yields on international bonds and debt instruments. The degree of such a change would obviously be dependent on how drastic of a change is seen in Dollar strength. Overall, based on our review of both industry and academic sources, we think any shift in the global currency regime is most likely to be a long term, gradual move away from overwhelming dominance by the Dollar toward a multipolar system where the Dollar remains at the forefront. Ultimately, we do not believe there is presently any reason to worry about the future of the greenback.

The views and opinions expressed as those of the sources listed and may not accurately reflect those of the individual or company providing you this document. Past performance is no guarantee of future results.

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